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Bundling Shareholder Proposals and Compensation Plans

Rule 14a-4 of the proxy rules prohibits the bundling of shareholder proposals.  17 CFR 240.14a-4.  The provision was added to the rule in 1992, replacing explicit language that allowed issuers to "group" proposals.  See Exchange Act Release No. 31326 (Oct. 16, 1992).  

The provision was recently at the center of litigation involving Apple and the its decision to group a number of amendments to the articles into the same proposal.  A court found that amendments had been improperly bundled and prohibited Apple from "accepting proxy votes cast in connection with" the proposal.  The opinion and briefs in the case can be found here

The staff of the Commission hasn't provided much guidance on this provision.  What little exists, however, is arguably inconsistent.  Some suggests that bundling is permissible for "immaterial" matters. See Rule 14a-4(a)(3), Division of Corporation Finance: Manual of Publicly Available, Telephone Interpretations, Sept. 2004 ("Unless the company whose shareholders are voting on a merger or acquisition transaction determines that the affected provisions in question are immaterial, those provisions should be set out as separate proposals apart from the merger or acquisition transaction.").

On the other hand, the Commission has issued advice that permits the grouping of proposals without referencing a materiality requirement.  See Exchange Act Release No. 7032 (Nov. 22, 1993) (“Companies have asked whether in the case of shareholder approval of amendments to an existing compensation plan, the ‘separate matter’ referred to in Rule 14a–4 applies to each amendment to the plan or only the plan as amended. Registrants have been advised that it is appropriate to provide for a single vote on the plan, as amended, rather than a vote on each amendment in a given plan.”). 

In the aftermath of the Apple litigation, a number of cases were filed alleging improper bundling. Groupon found itself involved in one such suit.  The complaint is here.  Other pleadings (including motions seeking attorneys fees) are here.  The case did not involve an amendment to the articles but an amendment to the company's incentive plan.  As the complaint stated: 

  • As stated in the Proxy, Proposal No. 4 seeks: "[t]he approval of the amendment to the Groupon, Inc. 2011 Incentive Plan to increase the number of authorized shares and to increase the individual limit on annual share awards." See Ex. A, p. 1. And as stated in the Proxy Card, Proposal No. 4 seeks "[t]o approve the amendment to the Groupon, Inc. 2011 Incentive Plan to increase the number of shares available under the plan and to increase the individual limit on annual share awards." See Ex. A, Proxy Card. 

The complaint asserted that "[p]laintiffs and Groupon's other shareholders can only vote for both of the proposed amendments, or against both of the proposed amendments" and that this constituted a violation of the anti-bundling requirements.

The case settled and therefore was not resolved by a court.  Other suits in this area have likewise involved compensation or incentive plans.  This suggests a need on the part of the staff of the Commission to provide guidance in the area.  The staff should indicate the types of changes that need to be addressed separately.  At a minimum, this should include an obligation to give a separate vote on amendments that are material.      


The Conflict Minerals Beat Goes On: SEC Issues Form SD

As discussed in several earlier posts, the conflict minerals rule promulgated by the SEC is currently under legal challenge in the US Court of Appeals for the District of Columbia (earlier posts are  here, here, and here).  Despite the uncertain future of the rule, the SEC has finally released its Form SD Specialized Disclosure Report.  Form SD is to be used to make the disclosures required under the conflict minerals rule and under the resource extractive industries rule (implementing Dodd-Frank Section 1504) if and when the SEC revises that rule, which was vacated by the US District Court for the District of Columbia last July.  The new Form SD, as it pertains to conflict minerals, must be filed on EDGAR no later than May 31 after the end of the issuer's most recent calendar year.

Form SD provides the mechanism pursuant to which covered issuers can file the required public report that includes the findings of their “reasonable” country-of-origin inquiry. The country-of-origin inquiry is designed to determine if the minerals used in issuers' products originated from the covered countries, which requires issuers to track and document the source and chain of custody of such minerals.

Form SD makes clear that “[t]his form is not to be used as a blank form to be filled in, but only as a guide in the preparation of the report.”   The precise content of Form SD filings will depending on how issuers can answer the following questions:

1. Are conflict minerals used in products that the issuer manufactures or contracts to manufacture?

2. Did the conflict minerals originate in the DRC or other countries covered by the rule?

Some of the specific requirements on Form SD include:

*Providing a description of the measures an issuer took to exercise due diligence on the source and chain of custody of conflict minerals;

*Disclosing the steps taken to mitigate the risk that its use of conflict minerals benefits armed groups if the issuer determines that its products are “DRC conflict undeterminable.” If a nationally or internationally recognized due diligence framework becomes available for the necessary conflict mineral prior to June 30, registrants must use that framework in the subsequent calendar year. If guidance does not become available until after that date, registrants are not required to use that framework until the second calendar year after it becomes available.

*If the issuer identifies any products that are not “DRC conflict free,” it must provide a description of products, the facilities used to process the necessary conflict minerals,  the country of origin of the necessary conflict minerals in those products, and the efforts to determine the mine or location of origin with the greatest possible specificity.

The SEC estimates that completion of the Form SD will average 480.61 burden hours per response.  The Form must be filed in standard HTML Cover and HTML Exhibit for Conflict Minerals report.

Issuers should already be far along in the process of conducting supply chain diligence if there is any question that their products are subject to the rule.  Issuance of Form SD simply makes more concrete the conflict minerals rule's requirements.  It may be that the efforts now being expended and those to be expended in the future will turn out to be for naught from a legal perspective if the conflict minerals rule is struck down, as many anticipate it will be.  That said, for those who think that companies should pay attention to their impact on social and environmental issues, the fact that issuers must engage in supply chain due diligence is a net positive.


Delaware Federal Courts and Fiduciary Obligations

We have noted that the "forum selection bylaws" upheld by the Delaware Chancery Court required that  actions for breach of fiduciary duty be brought either in the Chancery Court or in the federal district court in Delaware.  We further noted that the federal court in that jurisdiction does not appear to have the same degree of management friendly approach present in the state court system and therefore may represent a preferable forum for shareholder litigation. 

With that in mind, we turn to Lee v. Pincus, Civ. No. 13-834-SLR., 2013 BL 353897 (D. Del. Dec. 23, 2013), a fiduciary duty case brought in the Chancery Court but removed to the federal district court under SLUSA. 

According to the claim, Zynga, in connection with an IPO, obtained a lock-up agreement that "barred sales by substantially all of Zynga's shareholders, including all of its officers and directors, for 165 days following the December 16, 2011 IPO."  Zynga, according to the complaint, waived the lock up for its CEO and "other senior executives and private equity investors" so that they could participate in a secondary offering.  "[T]he same opportunity was not extended to Zynga's non-executive and former employees."  Plaintiffs alleged that the behavior violated state fiduciary duties.

SLUSA permits the removal of state claims that are really securities class action fraud cases.  SLUSA was not intended to interfere with traditional fiduciary duty claims. The federal court, therefore, had to determine the nature of the claims brought by plaintiff.  As the court reasoned:

  • Despite defendants' attempts to recast plaintiff's complaint to be preempted by SLUSA, the court finds that plaintiff has pled a core breach of the fiduciary duty of loyalty claim---whether executives can discriminate in favor of their own interests in waiving post-IPO lockup agreements that equally affect their share and the shares of other employees and outside investors. As the complaint shows, defendants told plaintiff and the world exactly what they were doing in the registration statement for the second offering---the only issue in the case is whether defendants were in fact entitled to favor their own interests in the manner they did under Delaware law. The court agrees with plaintiff that "fully disclosed trading" does not constitute "manipulation," "deceptive conduct," or a misrepresentation or omission.

As a result, the case was remanded back to the Chancery Court. 

The case wasn't about the quality of the case but about the nature of the claim.  Nonetheless, the court seemed to speak favorably about a somewhat unique fiduciary duty claim.  Now that it is back in state court, it remains to be seen whether the Chancery Court will share the same view. 


Forum Selection Bylaws and the Federal "Out"

As we noted in our third worst shareholder case for 2013, the Delaware Chancery Court has upheld the use of forum selection bylaws that require shareholders to litigate fiduciary duty cases in Delaware.  See Boilermakers Local 154 v. Chevron.  As a result, shareholders are forced to bring actions to a court system with a management friendly approach.   

The Chevron bylaw upheld by the court, however, provided shareholders with a slight "out."  The bylaw required that the case be brought in a "a state or federal court located within the state of Delaware, in all cases subject to the court’s having personal jurisdiction over the indispensable parties named as defendants."  As a result, shareholders can, if they can obtain jurisdiction, file in federal court. 

This is likely to be a less management friendly forum.  The federal court in Delaware, for example, struck down a system that allowed members of the Chancery Court to act as arbitrators in business disputes but that excluded the press.  Moreover, appeal from this court is not to the management friendly state Supreme Court but to the US Court of Appeals for the Third Circuit.  Indeed, the decision striking down the arbitration system was eventually upheld by the Third Circuit.  See Del. Coalition for Open Gov't, Inc. v. Strine, 733 F.3d 510 (3rd Cir. 2013).  It is hard to imagine the case coming out the same way had it been litigated in the state court system in Delaware.

Other states may not treat forum selection bylaws with the same degree of deference as the Delaware courts.  As a result, they may not work in forcing shareholder litigation into the Chancery Court.  Nonetheless, to the extent that they do, the federal "out" may be an option worth considering.  


Finding Value in Shareholder Activism

We are happy to repost this from the CLS Blue Sky Blog.

The following comes to us from Bernard S. Sharfman, Visiting Assistant Professor of Law at Case Western Reserve University School of Law.


Finding Value in Shareholder Activism

In this era of shareholder activism, there are still many attorneys and academics who believe that the traditional authority model of corporate governance (the “traditional model”) leads to optimal corporate decision-making and shareholder wealth maximization for large organizations.  This model favors the views of management over those of outside shareholders like institutional investors.  In the words of Professor Stephen Bainbridge, it is an approach to corporate governance where the “preservation of managerial discretion should always be the null hypothesis.”

However, even a strong proponent of the traditional model does not believe that corporate boards and executive management should act without some outside accountability.  Therefore, it would be fruitless to ignore numerous and repeated empirical studies that create a strong inference that hedge funds, and other shareholder activists, help maximize wealth when they invest large amounts of money in the equity of a public company and then advocate for certain types of corporate changes.   Professors Brian Cheffins and John Armour refer to this activity as “offensive shareholder activism.”

This inference does not detract from the traditional model but enhances it by identifying a legitimate tool of accountability that helps to increase shareholder value in some cases. This is exactly how Professor Paul Rose and I interpreted the meaning of these empirical studies in our recent article, “Shareholder Activism as a Corrective Mechanism in Corporate Governance.”

According to renowned economist Kenneth Arrow, “others in the organization may have access to superior information on at least some matters.” Therefore, it is legitimate to criticize centralized authority from time to time and acknowledge and accept the value provided by the “corrective mechanism.” In this case, the value provided by offensive shareholder activism.

In sum, it may be more productive for those who believe in the traditional model to move away from attacking the value of offensive shareholder activism and instead focus on attacking those who opportunistically or inefficiently participate in other types of shareholder activism.

By  November 22, 2013

The full article is available here.


SEC Press Release: Risk Alert On Options Trading Used To Evade Short-Sale Requirements

On August 9, 2013, the Securities and Exchange Commission's ("SEC") Office of Compliance Inspections and Examinations ("OCIE") issued a risk alert to help market participants detect and prevent options trading that circumvented an SEC short-sale rule ("Regulation SHO"). The OCIE's examiners observed option trading strategies that seem to avoid some of the Regulation SHO requirements. The Press Release is here: SEC Issues Risk Alert On Options Trading Used To Evade Short-Sale Requirements.

Regulation SHO was adopted in 2004 and regulates short sales.  See Exchange Act Release No. 50103 (July 28, 2004). "Short selling involves a sale of a security that the seller does not own or a sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller.”  Exchange Act Release No. 58773 (Oct. 14, 2008).  In doing so, short sellers profit from a decline in share prices.

Shares, however, occasionally become hard to borrow. In those circumstances, a pricing disparity can arise.  This occurs where the costs associated with acquiring the borrowed security are greater than the costs associated with a  “synthetic” put/call position designed to “mirror” the underlying security trades.  The disparity creates  an arbitrage opportunity whereby the short seller can profit by obtaining the synthetic position rather than the underlying security.

The Regulation SHO "close-out" requirement requires short sellers who fail to deliver securities after the regular trading hours on the settlement date to close out their position by borrowing or purchasing securities of like kind and quantity. The “close-out” requirement does not apply if the failure to deliver is attributable to "bona-fide market making activities by a registered market maker, options market maker, or other market maker obligated to quote in the over-the-counter market." In those circumstances, the short seller must close out the failure by "purchasing or borrowing securities of like kind and quantity by no later than the beginning of regular trading hours on the third consecutive settlement day following the settlement date."

OCIE observed transactions that would “give the impression of satisfying the Regulation SHO ‘close-out requirement,’ while in effect evading it.”  As the Risk Alert described:  

  • The trading strategies discussed in this Risk Alert could be used to give the impression that purchases by the short seller have satisfied the close-out requirement of the clearing firm or the broker-dealer to whom a fail to deliver position was allocated. We have observed, however, that in reality the purchased shares in question are often times not delivered because of subsequent options trading used to re-establish or otherwise extend the broker-dealer’s fail position without any demonstrable legitimate economic purpose, such that the clearing firm or broker-dealer allocated a fail to deliver position does not satisfy the close-out requirement.

In an effort to prevent settlement failures, the OCIE issued the risk alert to warn market participants of these sham close-outs that appear to comply with the close-out requirement by intentionally creating a fail to deliver situation and then replacing the short sale securities with actual securities. The risk alert identified many activities that may indicate an attempt to avoid the close out requirement of Regulation SHO, such as: "Trading exclusively or excessively in hard-to-borrow securities or threshold list securities, or in near-term listed options on such securities; [l]arge short positions in hard-to-borrow securities or threshold list securities; [l]arge failure to deliver positions in an account, often in multiple securities; and [c]ontinuous failure to deliver positions," among others.

The primary materials for this case may be found on the DU Corporate Governance website.


Hufnagle v. Rino International Corp.: Plaintiff Adequately Pleads Scienter in Claim for Securities Fraud against Company's Auditor

In Hufnagle v. Rino Int’l Corp., CV 10-08695, 2013 WL 3976833 (C.D. Cal. Aug. 1, 2013), the United States District Court for the Central District of California denied Defendant Frazer Frost, LLP’s ("Defendant") motion to dismiss Plaintiff’s Third Amended Complaint and held that Susan Hufnagle (“Plaintiff”), individually and on behalf of those similarly situated, properly alleged scienter under Section 10(b) of the Securities Exchange Act of 1934 (“§ 10(b)”).

In the original Complaint, Plaintiff alleged that Rino International Corporation ("Rino"), Rino’s management, and Defendant, Rino’s auditor, conducted widespread fraud regarding its Chinese industrial equipment business, including overstating revenue and profits, understating tax liability, and concealing transactions between Rino and companies managed by Rino’s CEO’s relatives. Subsequently, Plaintiff entered into a settlement agreement with, and dismissed the claims against, all defendants except Defendant.

In the Third Amended Complaint, Plaintiff alleged that Defendant knowingly or recklessly ignored financial irregularities, failed to follow generally accepted auditing standards when reviewing Rino’s financial statements, and issued false opinions concerning Rino’s financial statements.

In order to adequately plead a securities fraud claim under § 10(b) and Rule 10b-5, a plaintiff must allege facts that show (1) a material misrepresentation or omission of fact, (2) scienter, (3) a connection with the purchase or sale of a security, (4) transaction and loss causation, and (5) economic loss. Cases brought under the Private Securities Litigation Reform Act of 1995 ("PSLRA"), like Plaintiff's, must also meet the PSLRA’s heightened pleading standard, which requires the complaint to state with particularity facts giving rise to a strong inference that the defendant acted with scienter. If particular facts, when viewed individually, do not support a strong inference of scienter, a court must conduct a holistic review of the allegations. When viewed holistically, individually insufficient allegations can support a strong inference of scienter.

Defendant’s motion to dismiss specifically challenged whether Plaintiff had adequately plead scienter.

Plaintiff argued that the court should draw a strong inference of scienter from the fact that Defendant had actual knowledge that Rino kept two sets of corporate books, one of which provided inflated revenues and profits to investors, and that Defendant informed Rino’s management of significant deficiencies in Rino’s internal financial controls. The court found that the alleged facts gave rise to what it described as both "innocent" and "malicious" inferences.  Because the facts alleged allowed for both malicious and innocent inferences, the court determined the allegations alone did not support a strong inference of scienter.

Next, the court analyzed the allegations that Defendant instructed Rino to use an accounting technique that violated generally accepted accounting principles and that Defendant failed to check the status of the customers and contracts that were used to determine Rino’s future revenue. The court found that the alleged practices did not violate accounting standards, and thus the allegations did not support a strong inference of scienter.

The court determined that, viewed individually, the facts were insufficient to establish a strong inference of scienter. However, it found that, holistically and alongside the first two allegations, the allegations that Defendant knew that Rino advanced more than $34 million to suppliers that were owned by the CEO’s relatives and that Rino issued its CEO an interest-free, unsecured loan of $3.5 million to purchase a personal residence more readily supported the inference of wrongdoing. Thus, the court found that these allegations holistically supported an inference of scienter.

Accordingly, the court denied the Defendant’s motion to dismiss.

The primary materials for this case may be found on the DU Corporate Governance website.


Diversity and the Legal Profession

We spend a significant amount of time on this blog examining the issue of diversity.  Mostly it comes up in the context of boards of directors (although we also discuss it regularly with respect to the lack of women and people of color on the Delaware courts).  Nationally, women and people of color make up approximately 15% of boards.  For the most part, this means one person of color and one woman on each of the boards of the largest companies in the U.S.   

But this is not the only area that deserves criticism.  Recent data with respect to women in the legal profession is not good and, unfortunately, moving in the wrong direction.  According to the National Association of Legal Placement, women and minority partners increased slightly, minority associates increased somewhat, but the number of women associates fell for the fourth year in a row.    

  • Among associates, the percentage of women had increased from 38.99% in 1993 to 45.66% in 2009, before falling back each year since, to 44.79% in 2013. Over the same period, minority associate percentages have increased from 8.36% to 20.93%, more than recovering from a slight decline from 2009 to 2010. Representation of minority women among associates in the two most recent years just barely exceeded the 11.02% figure for 2009.

Moreover, while the numbers improved within the ranks of partners, they were still low.  As NALP reported:

  • In 2013 that slow upward trend continued for partners, with minorities accounting for 7.10% of partners in the nation’s major firms, and women accounting for 20.22% of the partners in these firms. In 2012, the figures were 6.71% and 19.91%, respectively. Nonetheless, the total change since 1993, the first year for which NALP has comparable aggregate information, has been only marginal. At that time minorities accounted for 2.55% of partners and women accounted for 12.27% of partners.

We've included a table at the end of this post with the statistics. 

The problem, however, starts at the front end. Since 2000 (and likely before) women have constituted less than half the students admitted to law school.  This is the case despite the fact that through much of the first decade of the new millennium, female applicants were equal to or outnumbered male applicants.  The number of women matriculants is also less than half of all law school graduates with 21,560 men and 19,700 women graduating in 2012.  Moreover, from 2011 to 2012, the decline in admitted students (down from 55,000 to 50,000) was almost entirely borne by non-Caucasian/white admittees (Caucasian students only fell from 35,920 to 35,620). So things aren't getting much better and there is reason to believe matters are backsliding. 

What is going on? It's not a lack of qualified candidates.  The only requirement (besides taking the LSAT) for admission to law school is an undergraduate degree.  And in that category, women are trouncing men. Of the population aged 25-34, 27.8% of the men and 35.6% of the women have a BA or higher.  So there is something about legal education and the legal profession that is discouraging women.  While the concern over the total decline in applications is catching most of the national news, perhaps this is a more important issue to address. 


Table 1. Women and Minorities at Law Firms — 2009-2013








% Minority Women



% Minority Women



% Minority Women



% Minority Women




































































Amending Dodd-Frank: Opposition to the Proposed Pay Ratio Rule

On September 18, 2013, the SEC proposed an amendment to the Dodd-Frank Wall Street Reform and Consumer Protection Act in a 3-2 vote. The amendment, called the “Pay Ratio Rule,” would require public companies to disclose the ratio of CEO compensation to that of the median compensation of employees. Since the proposal’s publication in the Federal Register, the SEC has received more than 20,000 public comment letters, many of which express adamant opposition to the ratio disclosures.

Proposal opponents argue that the benefits are outweighed by the burdens of the pay ratio disclosure. Critics are primarily concerned with the costs and complexities involved in calculating the median pay of a company’s workers (see CEO Pay Ratio Disclosure: Drilling Down on the Proposed Rule). According to Bloomberg, the proposal requires that the pay of all employees, including those overseas, be included in calculating median compensation. Business groups stress that the differences in “pay practices” in various countries across the world would be difficult to reconcile with disclosure practices in the United States. The usefulness of the proposed rule has also been challenged because director compensation is already a federally required disclosure, although the ratio is not.

During the comment period, the SEC received two significant letters opposing the rule from the National Investor Relations Institute (“NIRI”) and FEI Company (“FEI”). NIRI facilitates communications among all who are involved in the investment process (opposition letter available here). NIRI has over 3,300 members that represent over 1,600 public companies and “$9 trillion in stock market capitalization.” FEI is an international organization based in Oregon that operates within 50 countries. The company has 2,600 employees, 70% of which are based abroad (opposition letter available here). NIRI and FEI both emphasize that the Pay Ratio Rule is misleading, inconsistent, time consuming, and costly. FEI, which operates internationally, and NIRI, which advises all involved in the investment process, will both be affected should the proposed rule be implemented.

In opposing the rule, NIRI expressed concern over the misleading nature of such pay disclosures. Specifically, differing business structures, such as whether a company engages in contract labor or employment, could cause what would otherwise be a low pay ratio to be significantly higher, thereby having the potential to mislead investors. NIRI argued that, in turn, this would lead to uninformed investment decisions because investors may rely on the pay ratio calculation in lieu of considering other factors, such as the company’s past financial performance, compensation disclosures, and “business structure differences.” Moreover, the Department of Labor’s Bureau of Labor Statistics already publishes the average compensation of U.S. employees, which makes the cost of calculating median employee compensation unnecessary.

NIRI also highlighted the inherent inconsistencies that would result because public companies have discretion on how to calculate median employee compensation. Some companies are likely to incur significant expenses in ensuring the adequacy of the proposed required filings, while other companies will cut corners to avoid excess costs. The cost of compliance with the proposed rule is further heightened because it refers to “all employees,” including those overseas, instead of simply U.S.-based employees.

FEI based its argument against the proposal on the “complexity of arriving at the median wage globally” considering “currency fluctuations” and pay scale differences among countries. Furthermore, the cost of living varies among the countries in which FEI operates. This poses an additional problem with the rule because competitive pay within the United States is unlikely to be consistent with competitive pay abroad. Employees based abroad also receive different benefits that are not shared by the CEO, “including leased cars, more generous paid time off regimes, enhanced medical benefits as well as defined benefit pension plans.” FEI maintained that the differences among job markets in different countries are so inconsistent that the proposed pay ratio rule will skew compensation numbers by not taking into account external factors within each country individually. Both NIRI and FEI recommended that the rule include only employees based within the United States.

FEI claims that, as drafted, compliance with the rule would require large amounts of time and money. Specifically, FEI estimates expending more than 1,000 hours of time to determine a calculation method, plus 500 hours annually “to support an ongoing effort.” Not only would compliance with the proposal be incredibly time consuming, but it would also be extremely costly. FEI anticipated its initial cost of compliance for the first year to be approximately $250,000, and $100,000 annually after the method for determining the median employee is established.

In sum, the proposed pay ratio rule has received significant opposition from large corporations and proposal opponents, such as NIRI and FEI. These opponents contend that the rule would not provide any significant benefit to shareholders because implementation of the rule would be misleading, inconsistent, time-consuming, and extremely costly.


Amending Dodd-Frank: Comment Letters in Favor of the Proposed Pay Ratio Rule

The Securities and Exchange Commission (“SEC”) proposed a new rule in September designed to implement the requirements of Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).  Under the proposed rule, public companies must disclose median employee compensation and the ratio of the median employee’s compensation to the compensation of the company’s chief executive officer (“CEO”). The SEC received over 79,000 letters favoring the proposed rule during the 60-day public comment period. The Press Release is here: SEC Proposes Rules for Pay Ratio Disclosure.

Companies may calculate the median employee’s total compensation using any of the procedures described in Item 402(c) of Regulation S-K, the same method required by Section 953(b) of the Dodd-Frank Act, to calculate CEO compensation.

Many commentators agree with the SEC’s choice not to require the use of any particular method for determining the median of the annual total compensation of all employees of the company. The proposed rule allows a company to choose to analyze its full employee population, a group of employees chosen using statistical sampling, or other reasonable methods to calculate the median employee’s compensation.

Supporters also approve of the flexibility allowed in determining the total compensation of the pool of employees. Companies may calculate the median employee’s total compensation using the same procedures required to determine executive compensation in Item 402(c) of Regulation S-K or another reliable compensation measure, such as payroll or tax records.

The International Brotherhood of Teamsters (“Teamsters Union”) submitted a letter strongly supporting the SEC’s proposed rule (letter available here). In its letter, the Teamsters Union focused on how “[l]arge disparities in compensation within a company can harm productivity and employee morale which may negatively affect the company’s overall performance.” The Teamsters Union believes that pay disclosure will offer investors better insight into a company’s pay practices, and allow monitoring of changes in compensation over time as a metric for comparison of companies to their peers. Finally, the Teamsters Union expressed its belief that the SEC had properly balanced the costs of compliance with the new rule with the benefits of disclosure to investors.

The Laborers’ International Union of North America (“LIUNA”) also supports the proposed pay ratio disclosure rule (letter available here). LIUNA has more than 500,000 members that hold more than $34 billion in assets in the capital markets via LIUNA’s Individual Benefit Funds. LIUNA’s letter focuses on a “correlation between high CEO pay and poor company performance,” emphasizing that high CEO pay does not ensure a company’s financial success, and quoting statistics that one of every five of “the highest paid executives ran firms that received taxpayer money or collapsed during the financial crisis.” LIUNA also noted how valuable the pay ratio information is for LIUNA’s members when LIUNA votes on behalf of its members’ interests in LIUNA’s investments. Finally, LIUNA argued that the flexible methods allowed to calculate the median employee compensation use statistics that companies have already calculated, and therefore will not be overly costly.

The full text of the proposed pay ratio rule is available here.


Pay Ratio Disclosure: Form Comment Letter Types Received by the SEC

The Securities and Exchange Commission ("SEC") proposed a new rule in September under the Dodd-Frank Wall Street Reform and Consumer Protection Act. Under the proposed rule public companies required to provide summary compensation disclosure under Item 402(c) of Regulation S-K must disclose median annual total compensation and the ratio of the median employee’s compensation to the compensation of the company’s chief executive officer (“CEO”). The press release regarding the proposed amendment is here: SEC Proposes Rules for Pay Ratio Disclosure.

There have been a number of requests to extend the proposed amendment's comment period for an additional length of time past its closing date of December 2, 2013; however, the SEC did not extend it.

The SEC received a total of 122,441 form comment letters regarding the proposed amendment. There are eight different types of form letters the SEC received, all of which are in favor of the proposed amendment. The comments the SEC has received opposed to the proposed amendment have come mainly in the form of meetings with SEC officials, or personal letters neither of which are not discussed here.

What follows is a list of the form letters:

Type A: 19,960 received: Type A letters support a strong pay ratio disclosure rule. The main reason these letters support the rule is because the disclosure will benefit both consumer’s and investor’s decision-making. 

Type B: 12,856 received: Type B letters support the required disclosure. These letters emphasize that pay ratio disclosure will lead to fairer corporate pay structures, which will, in turn, lead to a stronger U.S. economy.

Type C: 20 received: Type C letters are from the General Truck Drivers and Helpers Teamsters Local Union No. 92 in Canton, Ohio. These letters support the disclosure and state that the pay ratio is material information that will allow investors to gain insight into corporations’ approaches to compensation and development of human capital.

Type D: 5,310 received: Type D letters are primarily sent by investors who have invested through their retirement plan or personal savings. These letters support the required disclosure and emphasize the practical use of the pay ratio when investors are evaluating executive compensation through say-on-pay votes.

Type E: 1,684 received: Type E letters are in favor of the required disclosure because it will help investors vote on CEO pay, scrutinize board performance, and identify possible investment risks.

Type F: 1,157 received: Type F letters support the required disclosure. These letters reiterate what other letters state and add that the ability to compare corporations pay ratios should “ratchet down” CEO pay (see previous discussions on the issue of whether the effects of disclosure actually raise or lower CEO compensation).

Type G: 15,249 received: Type G letters support the disclosure requirement and emphasize that it will help investors fight runaway executive pay practices. These letters state that runaway pay practices are linked to short-term executive philosophies, which encourage excessive short-termism and unethical acts.

Type H: 66,205 received: Type H letters support the pay ratio disclosure for two reasons. First, the disclosure would allow the public to see which corporations are fueling the growing gap between the rich and the poor. Second, the disclosure would allow investors to educate themselves about which corporations are expending resources on executive pay rather than putting resources toward long-term investments or workforce development. 


Proposed Item 402(u) Pay Ratio Disclosure: How to Find the Median Needle in Your Haystack

As prescribed by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the Securities and Exchange Commission (“SEC”) proposed an amendment to Item 402 of Regulation S-K, to be codified as Item 402(u). This amendment requires disclosure of a ratio of the total annual compensation of an issuer’s chief executive officer and the total annual compensation of the issuer’s median employee, excluding the chief executive officer. The full text of the proposal can be found here.

In the proposal, the SEC does not prescribe a specific method of identifying the median employee compensation of the issuer, but instead provides “instructions and guidance designed to allow registrants to choose from several alternative methods to identify the median, so that they may use the method that works best for their own facts and circumstances.”

Methods of Identifying the Median

Item 402(c)(2)(x) Compensation Determination. In a plain reading of the proposed amendment, the clearest way to comply with the determination of finding the median employee would be to determine the total annual compensation of each employee of the registrant under the terms set forth in Item 402(c)(2)(x) and then determine the median employee. This method would also truncate the process because there would be no need for a second calculation since the total annual compensation of the median employee would already be calculated. This is unlike the Statistical Sampling or Total Direct Compensation methods which require a two-step calculation process, which are described below.

Total Direct Compensation. In response to concerns over the cost of determining every employee’s compensation under Item 402(c)(2)(x), the SEC agreed to allow determination of median compensation using total direct compensation. This would include metrics such as annual salary, hourly wages, performance-based pay, or pay as indicated on IRS Form W-2. The SEC states that reduced costs would result from the use of the total direct compensation method. The SEC, however, directly disavowed allowance of earnings estimates from the U.S. Department of Labor’s Bureau of Labor Statistics as not being consistent with Section 953(b) of the Dodd-Frank Act.

Statistical Sampling. In the proposal, the SEC discussed statistical sampling as a valid method of identifying the median. As with total direct compensation, the proposal states that statistical sampling may lead to reduced compliance costs. However, in allowing the use of statistical sampling, the proposal states that the sample size required would vary depending upon the circumstances of the registrant. This variation would change the costs of performing the calculation. Once a sample has been determined, the proposal indicates that an exact compensation determination of each employee is not required. Instead, a registrant may identify outliers, either highly compensated or lowly compensated employees, and label them as above the median and below the median, while concluding that the median is not among the statistical sample.

Determination of Total Compensation

After the median employee has been identified by the issuer by one of the proposed methods or another reasonable way, the issuer must calculate the total annual compensation of the employee identified.

Section 953(b) mandate to use Item 402(c)(2)(x). The SEC noted that many commentators are concerned about the cost of going through a full Item 402(c)(2)(x) compensation analysis for the median employee, but such analysis is the prescribed manner for calculating total annual compensation by Section 953(b) of the Dodd-Frank Act. The proposal does indicate, however, that the registrant would have to disclose the total annual compensation of only the median employee in accordance with Item 402(c)(2)(x), even if the registrant elected to identify the median employee by calculating every employee’s compensation under that standard.

Reasonable Estimates of Item 402(c)(2)(x). In recognition of the costs and challenges of calculating the total annual compensation of a regular employee under Item 402(c)(2)(x), the SEC explicitly allows the use of reasonable estimates in determining any of the applicable elements of the median employee under Item 402(c)(2)(x). The SEC believes that this will not diminish the value of the metric, but if estimates are used, they must be clearly identified as an estimate amount and also include a description as to how that estimate was obtained.

As a final note, the SEC proposal requires disclosure of the method used to determine the median employee and total annual compensation and requires further that the method prescribed be applied consistently from one year to the next.

Key Issue and Why

The calculation of median employee compensation is crucial to the proposed amendment to Item 402. Many commentators have expressed their concern over the utility of such a metric, especially when faced with the potential costs of calculation.

For more information on this subject, see Professor J. Brown’s commentary here, here, and here.

For a summary of the proposed rule, see here.  


SEC Proposes New Rules for Pay Ratio Disclosure 

On September 18, 2013, the Securities and Exchange Commission (“SEC”) put forward proposed rule amendments.  Pay Ratio Disclosure, 78 Fed. Reg. 60, 560 (proposed Oct. 1, 2013) (to be codified at 17 C.F.R. pts. 229 & 249)

The new rule, required under Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), requires the disclosure of pay ratios of the annual compensation of the CEO compared to the median of the total worker pay of the company’s employees. Included in “employees” are all full-time, part-time, temporary, seasonal, and non-U.S. employees. In addition, those employed by the subsidiary of the company and any employee working on the last day of the company’s prior fiscal year are included in the calculation.

Under the proposed pay ratio disclosure, only companies required to prepare a Summary Compensation Table under item 402(c) of Regulation S-K would be subject to the requirements. Those exempt from the proposed requirements would be smaller reporting companies, foreign private issuers, and emerging growth companies. However, newly public companies subject to the rule will only be required to comply “the first fiscal year beginning on or after the date the company becomes subject to the reporting requirements” of Section 13(a) or 15(d) of the Securities Exchange Act of 1943.

The proposal would not require companies to follow specific calculation methods, allowing flexibility to use sampling and other estimation methods to determine the median pay of employees. The SEC also provided a method that allows companies to estimate the median compensation of a single employee without having to conduct complicated calculations for every employee.

The purpose of the proposal is to provide greater disclosure by companies regarding their CEO’s annual compensation. Robert Menendez, a New Jersey Democrat who wrote the Dodd-Frank provision requiring the disclosure, believes that CEO compensation has increased significantly while “middle class Americans . . . have gone years without seeing a pay raise . . . .” Democratic SEC commissioner Luis A. Aguilar also believes disclosure is in the best interest of shareholders because disclosure would provide greater detail to shareholders who are then able to compare worker and CEO pay compensation to the company’s success during each fiscal year. Not everyone, however, supports the proposed pay ratio disclosure. Some groups view the proposed rule as highly controversial, overly burdensome, and a tactic designed to “shame CEOs and public companies.”

The proposed rule was subject to a 60-day public comment period following its publication in the Federal Register on October 1, 2013. Comments were due on or before December 2, 2013. Whether and when the new rule will be effective is still undergoing determination. The Federal Register publication is here


Delaware's Top Five Worst Shareholder Decisions for 2013 (A Recap)

It was neither a particularly good or bad year for shareholders in Delaware in 2013.  The cases discussed in this series of posts can be described as management friendly.  This reflects a consistency in interpretation rather than any significant change.

The Top Five Worst Shareholder decisions for 2013 were:


#1:   Chancery Court Domination of the Delaware Supreme Court

#2:   In re MFW Shareholders Litigation (Rendering duty of loyalty inapplicable in some cases involving a   controlling shareholder)

#3:   Boilermaker Local 154 v. Chevron (Upholding forum selection bylaws)

#4:   Freedman v. Adams (Evidence of the impossibility of establishing waste with respect to executive compensation)

#5:   Louisiana Municipal Police v. The Hershey Company (Reaffirmation on limitations imposed on shareholder inspection rights)



Delaware's Top Five Worst Shareholder Decisions for 2013: Chancery Court Domination of the Delaware Supreme Court  (#1)

Delaware has long been a management friendly jurisdiction, particularly with respect to the interpretation of fiduciary duties by the courts.  At the same time, however, the degree of friendliness has varied.  Back in the 1980s, the Delaware Supreme Court decided a number of landmark cases where shareholders occasionally won (think Van Gorkom) or at least didn't entirely lose (think Unocal). 

Today, however, this no longer seems to be the case.  Shareholders routinely lose most major cases that make their way to the Delaware Supreme Court.  Admittedly, this is a feeling more than matter of empirical data.  Yet the examples are there.  In cases such as Airgas v. Air Products, the Supreme Court reversed a well reasoned and somewhat shareholder friendly decision from the Chancery Court.  In a later decision in the same case, the Chancellor chaffed over standards imposed by the Supreme Court that obligated him to uphold a poison pill.   

To the extent that the courts have become more friendly to the positions of management over time, the search for an explanation represents a useful function.  One possibility is the background and makeup of the Supreme Court.  The existence of a Supreme Court in Delaware is a relatively new phenomena.  The Court was created in 1951, the last state to put one in place.  See Henry R. Horsey and William Duffy, THE SUPREME COURT OF DELAWARE After 1951:  The Separate Supreme Court (“The climax came in 1951 when Delaware became the last state in the union to create a separate Supreme Court.”).  At the time, only three Justices served on the Court, a number increased to five in 1973.  Id.  (noting that until then, "the Delaware Supreme Court was the only court of last resort in the nation with fewer than five members."). 

When Van Gorkom was decided in 1985, the decision was heard en banc by all five justices.  The members of the Court consisted of:  Chief Justice  Herrmann, and Justices McNeilly, Horsey, Moore and Christie.  Herrmann, Horsey and Moore were in the majority; McNeilly and Christie in dissent.  Before arriving at the Supreme Court, both McNeilly and Christie came from the bench, having served on the Superior Court.  The court has broad jurisdiction but does not hear cases in equity.  See Superior Court of Delaware:  Legal jurisdiction ("Superior Court has statewide original jurisdiction over criminal and civil cases, except equity cases, over which the Court of Chancery has exclusive jurisdiction, and domestic relations matters, which jurisdiction is vested with the Family Court.").  

Horsey, Moore and Herrmann, in contrast, came out of private practice (although Herrmann had served on the Superior Court six years earlier before resigning and going back into private practice).  So the Court consisted of a majority of members from private practice.  Moreover, the Court had no one who was "promoted" from the Chancery Court.  

Jump ahead to 2010 and the shareholder unfriendly decision in Airgas v. Air Products (Nov. 23, 2010).  The decision, like Van Gorkom, was heard by all five members of the Delaware Supreme Court.  They consisted of Chief Justice Steele, and Justices Holland, Berger, Jacobs, and Ridgely (the author of the opinion).  Before coming to the Supreme Court, three of the Justices served on the Chancery Court (Berger:  (1984-1994);  Jacobs (1985-2003);  Steele (1994-2000) ).  A list of the Chancery Court Chancellors and Vice Chancellors is hereSteele also served on the Superior Court as did  Justice Ridgely.  Only Justice Holland came out of private practice, having worked for a significant Delaware law firm.     

So, 25 or so years later, the makeup of the Court has changed significantly.  No longer are lawyers from private practice routinely placed on the Supreme Court.  Moreover, while courts in both eras had some members with prior judicial experience, the lower court of choice has changed significantly.  Instead of the Superior Court serving as a stepping stone to the Supreme Court, as was the case in the 1980s, the Chancery Court has become the stepping stone in the new millennium.    

The relationship between the background of the Justices and the degree of friendliness (or unfriendliness) toward shareholders is a matter of speculation.  Moreover, the domination of the Supreme Court by former Chancellors/Vice Chancellors is recent and may be temporary. 

Nonetheless, the issue is worth following.  As we have observed on this Blog, those serving on the Chancery Court offer a robust body of information about their judicial temperament and philosophy, particularly in connection with business related cases.  In contrast, those coming out of private practice have had less opportunity to demonstrate their judicial disposition.  For politicians trying to assess the judicial disposition of a possible appointee to the Supreme Court (uncertain though that may be), experience on the Chancery Court rather than in private practice arguably provides a better basis for doing so.    


Delaware's Top Five Worst Shareholder Decisions for 2013: In re MFW Shareholders Litigation (#2)

With the effective reversal of Van Gorkom (see Disney) and the universal adoption of waiver of liability provisions (see Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom), the duty of care has largely become an entirely process driven standard that imposes no real substantive obligations on directors.  

Substantive duties do arise out of the application of the duty of loyalty.  In those cases, the board has the obligation to show that a transaction was fair.  Unlike the process driven standard of the duty of care, fairness requires an analysis of the substantive terms of the transaction. 

The duty of loyalty can come up in a number of circumstances but most often applies where a conflict of interest is present in the boardroom.  This occurs where a director materially benefits from the decision.  In these circumstances, the courts cannot presume that the board acted in the best interests of shareholders.   

The trend in Delaware, however, has been to reduce the application of the duty of loyalty.  A conflict of interest analysis does not even apply so long as all shareholders received the same benefit.  Thus, even if a controlling shareholder induces a board to pay a dividend that it shouldn't pay, the analysis is the duty of care since all shareholders receive the same per share payment.  The controlling shareholder's potential interest in inducing a dividend for its own benefit is, for the most part, irrelevant.  

Similarly, the courts in Delaware made clear in recent decades that a conflict of interest will generally be neutralized if the board consists of a majority of independent directors.  Given that exchange traded companies are required to have a majority of independent directors, Deleware courts have effectively rendered the duty of loyalty inapplicable to transactions involving the CEO of publicly traded companies.  This is particularly true with respect to the determination of CEO compensation.  This erosion is discussed at greater length in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.

One place, however, where the duty of loyalty was preserved, at least in part, was in connection with transactions involving a controlling shareholder.  The duty of loyalty required the board to show that the transaction was fair.  Boards could lessen this burden by relying on a special committee consisting of informed and independent directors.  In those circumstances, the board obtained a shift in the burden of proof.  Shareholders were obligated to demonstrate that the transaction as "unfair."  Nonetheless, even with this shift in the burden, fairness still mattered.  Courts could not resolve the case entirely through an analysis of the process but had to consider the fairness of the substantive terms of the transaction.  

In 2013, however, this redoubt of the duty of loyalty crumbled.  In In re MFW Shareholders Litigation (we posted on it here), the Chancery Court considered the impact of a transaction involving a controlling shareholder where the board used a special committee of independent directors and conditioned acceptance of the transaction upon the approval of a majority of the disinterested (or minority) shares.  Given the double layer of procedural protections, the court concluded that the applicable standard of review would be the duty of care.  In other words, fairness and the substance of the transaction became irrelevant.  Only the process mattered.

Rigorous process could justify a change in the standard of review. But in Delaware, process is not rigorously enforced (the analysis of the independence of the Special Committee in MFW illustrates this).  There is no guarantee that the courts will ensure that the added process (approval of disinterested or minority shares) will in fact operate to protect shareholders. Already, the courts seem to be taking a lax view toward the meaning of "disinterested" shares. 

Moreover, the decision operated under a mistaken premise.  The court essentially viewed shareholder approval as something akin to proof of fairness.  As the opinion reasoned:   

  • [M]arket realities provide no rational basis for concluding that stockholders will not vote against a merger they do not favor. Stockholders, especially institutional investors who dominate market holdings, regularly vote against management on many issues, and do not hesitate to sue, or to speak up. Thus, when such stockholders are given a free opportunity to vote no on a merger negotiated by a special committee, and a majority of them choose to support the merger, it promises more cost than benefit to investors generally in terms of the impact on the overall cost of capital to have a standard of review other than the business judgment rule. That is especially the case because stockholders who vote no, and do not wish to accept the merger consideration in a going private transaction despite the other stockholders' decision to support the merger, will typically have the right to seek appraisal.

The implication is that traditional institutional investors will be in a position to make a reasoned decision about the fairness of the transaction and if they determine it is unfair will vote against it. Perhaps. But they are not the only investors that will be voting on the transaction.  

Once a merger has been announced, the ownership configuration of a company commonly undergoes substantial change.  Risk averse shareholders sell to professional investors such as arbitrageurs.  So long as the professional investors purchased shares at an amount below the offering price, they profit through completion of the transaction, irrespective of its actual fairness.  Thus, a merger may be approved by "disinterested" shareholders but still be unfair. 

The Delaware courts show no interest in taking this change in the ownership configuration into account.  They have shown little willingness to police the use of the record date when used to enfranchise arbitrageurs and other investors that purchase after the announcement of the merger.  

On the other hand, the courts in Delaware have shown a willingness to reduce the instances where management decisions are subject to review under the duty of loyalty.  In re MFW is the latest example. 


Delaware's Top Five Worst Shareholder Decisions for 2013: Freedman v. Adams (#4)

The management friendly nature of the Delaware courts is probably most obvious with respect to CEO compensation.  Although the CEO sits on the board and is therefore in a position to influence the board's decision, courts in Delaware have resolutely refused to apply the duty of loyalty to the transaction. 

Instead, as long at a board has a majority of "independent" directors, the applicable standard of review is the duty of care.  Because the duty of care is a process standard, the amount of compensation essentially doesn't matter as long as the board, in a "check-the-box" sort of way, engages in the proper procedural steps.  Moreover, as the Disney case has shown, these can be minimal.  As a result, shareholders are limited to a claim for waste, an all but impossible standard to meet.  The result is CEO compensation without limits.

Each year, it seems, there is a decision that reaffirms this approach.  The candidate in 2013 was Freedman v. Adams, 58 A.3d 414 (Del. 2013).  A post on the case is here.  In Freedman, a shareholder alleged that the company had paid more than $130 million in executive bonuses.  The shareholder also alleged that the board failed to adopted a plan that would have made the bonuses in excess of $1 million deductable under IRC 162(m), ostensibly saving the company $40 million. 

The shareholder asserted that this amounted to waste.  The board reiterated the standard:  Waste required a showing that the board authorized an "action that no reasonable person would consider fair . . . ."  The court found that the allegations were insufficient to demonstrate waste for two reasons:

  • First, although Freedman alleges that the benefits of having a Section 162(m) plan are "obvious," the complaint does not allege that any of the bonuses paid to XTO's executives actually would have been tax deductible under such a plan. Second, the XTO board was aware of the tax law at issue, but intentionally chose not to implement a Section 162(m) plan. The board believed that a Section 162(m) plan would constrain the compensation committee in its determination of appropriate bonuses. The decision to sacrifice some tax savings in order to retain flexibility in compensation decisions is a classic exercise of business judgment. Even if the decision was a poor one for the reasons alleged by Freedman, it was not unconscionable or irrational.

The court's analysis demonstrated the impossibility of the standard for waste under Delaware law.  It was not enough to get past the demand excusal stage to allege a $40 million loss and to allege that the loss could have been avoided.  To defeat the claim, the company needed only to provide a possible justification for the approach.  In this case, the board asserted that the decision allowed it to "retain flexibility" with respect to compensation.  

This was enough for the court.  The actual substance played no role in the analysis. The court made no effort to determine whether the flexibility actually resulted in any benefit to the company or whether the benefit equaled anything approaching the $40 million in tax savings foregone.   

Compensation is increasingly becoming a federal matter.  Congress imposed "say on pay" in Dodd Frank and provided shareholders with an advisory vote on compensation.  Financial regulators (including the SEC) were given the authority to bar certain compensation practices at large financial institutions.  Next year, according to the Unified Agenda, the SEC will be proposing or implementing a number of rules that directly address compensation (the pay ratio rule, mandatory clawbacks of performance based compensation, increased disclosure requirements).

As long as the Delaware courts continue to implement a standard that permits compensation without limits, federal preemption will continue.  


Delaware's Top Five Worst Shareholder Decisions for 2013: Louisiana Municipal Police v. The Hershey Company  (#5)

One of the most discussed issues at the federal level concerned the obligation of the Commission to impose disclosure requirements that had social importance but provided modest additional value to shareholders. 

Conflict minerals and resource extraction payments were two examples. Both were required in Dodd-Frank, and both were litigated (for a post on resource extraction payments, go here; for one on conflict minerals, go here).  Moreover, as the Chair of the SEC has noted:

  • But other mandates, which invoke the Commission’s mandatory disclosure powers, seem more directed at exerting societal pressure on companies to change behavior, rather than to disclose financial information that primarily informs investment decisions.  That is not to say that the goals of such mandates are not laudable.  Indeed, most are.  Seeking to improve safety in mines for workers or to end horrible human rights atrocities in the Democratic Republic of the Congo are compelling objectives, which, as a citizen, I wholeheartedly share.  But, as the Chair of the SEC, I must question, as a policy matter, using the federal securities laws and the SEC’s powers of mandatory disclosure to accomplish these goals.

Reservations at the Commission notwithstanding, the need for this type of disclosure will only grow.  Some investors want the information, particularly those with an investment philosophy that takes into account socially responsible activities of corporations. In other cases, demand will come from the public at large. 

But the need for federal intervention is at least in part a consequence of the unavailability of this type of information under Delaware law.  Under the state law right to inspect, shareholders must have a "proper purpose" for doing so.  Delaware courts have developed an excessively narrow interpretation of the phrase, limiting it, for the most part, to allegations of misconduct by management. 

Shareholders must do more than allege a proper purpose.  They also, at the pleading stage, must allege a "credible basis" for any proper purpose.  In assessing whether plaintiffs have met this burden, courts generally refuse to allow the standard to be met through inferences drawn from information in the public domain. The effect is to impose an all but impossible burden on shareholders. 

An example of this approach in 2013 arose in Louisiana Municipal Police Employees Retirement System v. The Hershey Company.  Plaintiffs sought books and records designed to examine the role, if any, played by Hershey in the use of child labor in connection with the production of cocao.  According to the court, plaintiffs alleged that: 

  • (i) Hershey is a major player in the chocolate industry that uses cocoa beans and products derived from cocoa beans, (ii) child labor is endemic in two countries that produce a large portion of the cocoa beans, and (iii) some of  products originate in those countries . . . .

As the court put it:  "The question this case presents is whether illegal conduct within one sector of an industry provides a credible basis from which this Court may infer that wrongdoing or mismanagement may have occurred at a company in that industry." 

The court answered this question with a no.  The fact that shareholders -- as owners of the company -- might want to know more about the relationship between cocoa and child labor was irrelevant.  The only purpose deemed "proper" was one alleging misconduct.  Moreover, to get the documents, shareholders had to present affirmative evidence (a credible basis) that misconduct had occurred. 

Shareholders of Hershey and the public at large might want to know more about the purchase of cocoa and the relationship to child labor.  But the information won't come from state law inspection rights.  As a result, disclosure requirements for these types of issues -- conflict minerals, resource extraction payments, and child labor -- will have to be imposed at the federal level and will require the SEC to use its "powers of mandatory disclosure."   


Delaware's Top Five Worst Shareholder Decisions for 2013 (Introduction) 

For the seventh year in a row (for prior listings, see 2012,  20112010, 20092008, and 2007), we ring in the new year with a retrospective on the decisions from the prior year that were the least favorable to shareholders.  There are, as usual, a bounty of choices.  Nonetheless, as in prior years, we narrow the list to five.  Anyway, on with the countdown of the five worst shareholder decisions by the Delaware courts for 2013.


In re Tremont Securities Law, State Law, and Insurance Litigation (Elendow Fund, LLC v. Rye Select Broad Market XL Fund): The Heightened Pleading Standards for Securities Fraud Claims under the PSLRA

In In re Tremont Sec. Law., State Law, & Ins. Litig. (Elendow Fund, LLC v. Rye Select Broad Mkt. XL Fund), Master File No. 08 Civ. 1117, 10 Civ. 9061, 2013 BL 249529 (S.D.N.Y. Sept. 16, 2013), Plaintiff Elendow Fund, a small investment fund, filed suit against Rye Select Broad Market XL Fund (“XL Fund”), Rye Investment Management, Tremont Partners (“Tremont”), and other entities alleged to be directly and indirectly involved in the exchange of XL Fund investments (collectively, the “Defendants”) in an effort to recover assets lost as a result of the Bernard Madoff Ponzi scheme. Elendow Fund’s complaint made several allegations including securities fraud, control-person liability, and violations of various state-law provisions. The Defendants moved to dismiss and the United States District Court for the Southern District of New York granted the motion.

According to the allegations, XL Fund engaged in an investment strategy that entailed, among other things, investments in a fund managed by Bernard Madoff. Tremont allegedly “induced” Elendow Fund to invest in XL Fund through misrepresentations. Tremont’s alleged misrepresentations included statements about the investment strategy of the XL Fund.  Tremont also allegedly misrepresented the due diligence that it performed on fund managers.  Elendow Fund also brought claims for control-person liability.

Actions for securities fraud allegations are subject to the heightened pleading standards set out in the Private Securities Litigation Reform Act and Rule 9(b) of the Federal Rules of Civil Procedure. To meet these requirements, a complaint must identify “each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.” § 78u-4(b)(1). Furthermore, plaintiffs must also allege a “strong inference” of scienter. This requires allegations: “(1) showing that the defendants had both motive and opportunity to commit the fraud or (2) constituting strong circumstantial evidence of conscious misbehavior or recklessness.”

Elendow Fund argued that its complaint met the heightened pleading standard for securities fraud. The court, however, disagreed. The complaint did not “specifically and plausibly allege that Tremont actually knew that Madoff’s operation was a fraud.” With respect to the allegation that Tremont recklessly disregarded red flags, the court found that the complaint failed to sufficiently allege facts to establish that “the dangers posed by Madoff were so unmistakable that Tremont must have known that its representations were false.” The court further noted that Tremont recognized the risks and benefits associated with investing with Madoff, but nonetheless chose to continue doing so.  

The court also found that Elendow Fund’s allegations about Tremont’s due diligence were insufficient to plead securities fraud. Specifically, the court highlighted the fact that the complaint failed to sufficiently allege that some of the statements (the promise to perform “careful” due diligence posted on the Internet) were false. More specific representations about the level of due diligence in Tremont’s Form ADV failed because of the vagueness of the allegations. As the court reasoned:

This allegation might have been sufficient if, in context, it clearly referred to any specific representations. But this allegation appears, not alongside any allegations of actual representations, but in the formulaic recitation of the elements of count I of the complaint. In that context it is not clear what “statements described above” the allegation refers to. When an allegation couched in such generic language is completely separated from the substantive, factual allegations of the complaint, it is simply too vague to support an action for securities fraud under the applicable heightened pleading standards.  Elendow Fund’s generic allegation that it relied upon such representations as those described in the complaint is simply not adequate to push its reliance allegation over the line from conceivable to plausible.

Accordingly, the court dismissed the securities fraud claim. In absence of a primary violation, the court also dismissed Elendow Fund’s claim for control-person liability. Additionally, the court dismissed all of Elendow Fund’s state-law claims.

Therefore, the United States District Court for the Southern District of New York granted Defendants’ motion dismissing Elendow Fund’s complaint in its entirety.

The primary materials for this case may be found on the DU Corporate Governance website.